Venture capitalists hedge optical bets

TRENDS

By ROBERT PEASE

Investment in startup optical-networking companies, once a steady stream, has slowed to a trickle. In fact, there has been a 50-70% reduction in the amount of capital flowing into the optical sector over the last two years. Venture capital (VC) firms are getting particular about who gets funded and who doesn't-and they're holding onto their wallets unless they hear a very compelling story. The list of companies fitting that criteria is shrinking, they say.

"Today, you've got to not only convince one or two VCs, but you need to convince a half-dozen or more that you have a compelling idea," says Bill Cadogan, general partner at St. Paul Venture Capital (Minneapolis). "More than anything else, VCs don't want to be alone in a deal. They want to see strong syndicates and multiple investors that have enough money to carry the company through these challenging times."

Cadogan likens the VC environment as a cycle alternating between greed and fear. Two years ago, investors were elbowing each other out of deals to get a bigger piece of a particular company. Today, that greed has given way to fear and uncertainty.

"As they observe this seemingly never-ending downturn, they can't afford to be caught in the middle when a company runs out of money," says Cadogan. "They need a few other players around the table that can stitch together an inside round, if necessary, to keep a company going. So it's a rather dramatic change in terms of outlook."

As incumbent local-exchange carriers (ILECs) pare back on their capital spending plans, it has a snowball effect on equipment vendors, large and small. The optical sector is more entrenched than ever before, and they are targeting money at "here and now" products that address the ILECs' pain points.

The "paradigm changing" companies that were touting the birth of bleeding-edge technologies like all-optical switching and convergence onto an all-IP network are struggling to get funding today. The optical technology outlook-once just around the corner-has been delayed, and nobody is sure of when some of these legitimate technologies will once again gain traction.

U.S. vs. U.K. investment
A similar downturn is affecting investment in the United Kingdom., although not nearly as severe as in the United States. That may be due to the European community remaining true to their capital spending directions and still spending, although not in large quantities, in support of their original strategic or architectural plan of two years ago.

"I believe [that] in Europe the highs were not as high, and the lows were not as low," says Cadogan. "They never really saw the irrational exuberance that we saw here in the U.S., followed by the despair that a number of startups are feeling today. Rather, I think they've had a much more balanced point of view through the last two or three years."

However, the European optical market has still slowed significantly and the number of funded deals has noticeably decreased. Everardo Ruiz, senior manager for strategic investments in optical and wireless at Intel Capital, has a less optimistic view of the telecommunications economy in Europe.

"Optical communications, whether we're discussing systems or components, is a global business," says Ruiz. "The economic climate worldwide has slowed, affecting everyone in and outside of the U.K. VC has returned to a more reasonable, normal time where doing solid due diligence is an integral part of the process. For 'follow-on' deals, strong investors continue to support promising companies but at much lower valuations.

In both the U.S. and U.K., the days of three guys and a business plan at $30 million pre-money valuation are over-finally."

Who gets the money?
So what does it take for startup optical companies to get the attention of the VC community? Both Cadogan and Ruiz agree that a strong management team, with experience and focus, is the key. The focus of the management team should involve three concepts: focused strategy, strong financial controls, and customer traction.

The technology must focus on solving a real "hot button" from the customer while leveraging existing infrastructure. The company must demonstrate financial controls in terms of spend rate, because funding is no longer automatic. Finally, the product has to be advanced enough so customers understand it and react to it, showing a positive predisposition to buy the product when it becomes available.

"All three points are verified through due diligence," says Cadogan, "and if all three are not in place, there are lots more deals out there that are competing for the money. VCs today can be very selective in terms of where they choose to invest."

The timeline to recovery is anyone's guess. Some market researchers suggest an economic resurgence in about two years. The power has swung over to the ILEC purchasers who are asking for faster, cheaper, better, easier to install, and easier to maintain.

Technologies expected to lead the way to recovery include Gigabit Ethernet, tunable technologies, semiconductor-based components, and software. The bottom line is that ILECs are "all ears" when it comes to reducing capital expenditures and to neat twists on provisioning efficiency whereby they can also reduce operating expenditures.

VCs are still interested in investing in optical technologies but not until after due diligence has been satisfied. "Some investors are avoiding the optical sector after being burned," says Ruiz. "I think this is a great time to invest in solid teams and real revenue companies at very attractive valuations."

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